Why such a struggle to advance renewable fuels?: The (non-cooperative) games people play

Are there reasons that mandates and subsidies have a hard time stabilizing, or driving volumes of advanced biofuels or green chemicals — reasons that are grounded in the Prisoner’s Dilemma and game theory? 

Is there another, better way to advance the advanced bioeconomy?

Classical economics is grounded in the analysis of choices between “guns or butter” based on “supply and demand “ expressed in the form of a price— and presupposes a rational market of actors.

The nonsensical noise

But consider the food vs fuel problem, in the world of biofuels. Any review of the hard data would quickly confirm that the global supply of calories, per capita, is higher today than at any point in human history. If anyone is going hungry tonight, it is entirely to do with the inequitable distribution of money and food, not the volume of food production.

Yet, economic actors all over the world have abandoned the “use of food crops to make fuels” while almost no-one is seriously tackling the wealth problem.

It points out one reason why the “food vs fuel” debate is such an irritant to classical economists. They see it as nonsense. Yet, the wholesale, globalized “back-away” from “food” crops as a feedstock for advanced fuels, well, it’s reality. It’s non-sensical but not in the same way that unicorns are.

More nonsense? We see that Solazyme dropped nearly 66% in share value after disclosing troubles in its steam and power supply. But recovered only a few percentage points of that this week after announcing that it had fixed the problem, in what the analyst Jeffrey Osborne described as a “key inflection point.” Where’s the recovery?

Need more? How about President Obama’s EPA backing away from the Renewable Fuel Standard because they lack confidence that renewable fuels can be distributed in the originally targeted volumes. Yet, the Administration is pushing electric cars via $7,500 tax credits when re-charging infrastructure is hard to find and connects, if you find it, to a grid mainly powered by coal and natural gas. The grid is as green as the Chinese flag.

Why is Renewable Energy Group trading at 11 times earnings, compared to the NASDAQ average of 24.9, in this mother-of-all-bulls market — despite a huge locked-in uptick in the biomass-based diesel mandates over the next few years?

Why, why, why? Why all the nonsense? Isn’t most financial analysis of the industry based around the idea of discounted cash flows? Don’t we simply rate stocks and projects based on future cash flows and discounted for time span and risk (market, policy, technology, country and feedstock, among them). Why do we see huge discounts between traded values and analyst price targets? Why do we see all this nonsensical noise?

Some other, very powerful force is at work here — all across the spectrum of renewable fuels. Stocks, policy, carbon, mandates, everywhere. They may be nonsensical noises but they are not not hallucinations. As with dark energy and dark matter, we may need to revise our standard model of how and why things work.

The Prisoner’s Dilemma

For some intellectual framework, we may find relief in the logic of non-cooperative games and game theory.

Let’s take, as a starting point, The Prisoner’s Dilemma. Two criminals are apprehended, and taken to separate cells. They’re facing 10 year sentences if convicted.  The police offer a deal to each — rat on your fellow criminal and you’ll get off free. Unless you both rat on each other, in which case you each get three years. If you both say nothing, both go free.

Here’s a chart which visualizes the problem.

Here we have four possible outcomes — A and B both rat, A or B rats but not the other, or both say nothing. The penalties in this range are: (a) 3 years each, (b) 10 years for one and scot-free for the other, or (c) scot-free for both.

In a perfect world, of course, the prisoners co-operate, neither “rats” and they both go home. We see that clearly in the mathematics. Seen from the point of view of “the community” (in this case, the two prisoners) there’s a clear benefit for B not to rat. The result is a community loss of “16” if he rats, “10” if he stays silent. Silence is golden, in a co-operative world, where we work for the brotherhood of man.

But we do not live in an outtake from “Hair“. We live in a non-cooperative world. and B is “investing” for himself. Seen from B’s perspective, there’s a loss of “10” if he says nothing, a loss of “3” by ratting. So, he rats.

In fact, players A and B, knowing their own strategy and also knowing the strategy and returns for the other, rat every time. It’s a stable result you can count on — it’s optimal for each player within the context of the game. It’s known as a Nash equilibrium — which you may recall from college classes or from John Nash’s life story related in A Beautiful Mind.

The Carbon Dilemma

So, here’s the problem in a multi-player game, when we turn to the problem of investing in the carbon economy. We have the prisoner’s dilemma all over again. You see, no matter what one company does, it matters what the other company does, because the atmosphere is a community asset.

So, let’s look at the problem. Should Company A stay dirty, knowing its opportunities but also understanding the strategies of its competitor Company B?

Or, should it invest in carbon solutions that may have near-term costs, but profound long-term benefits. Or, if you like to think of nations investing in carbon standards, that’s fine too — it’s a question of whether Nation A should invest, understanding Nation B’s strategy.

We have four possible outcomes — neither invests, A invests but not B, B invests but not A, or they both invest.

If both invest, the world is a better place and they recoup their investment and maintain market share. If neither invests, the world is a worse place economically in the long-term because of climate change costs, but they maintain relative market share.

If one invests and the other doesn’t, they both get the limited reward of limited climate change action, but one bears all the cost and loses value because of loss of market share or margin compression because all the burden of the new economy is falling on one company, not both.

So, here’s our chart.

And here’s the problem. Seen from the point of view of “the community”, there’s a clear benefit for B to invest. The result is a community loss of “16” if they fail to invest, “10” if they invest.

But we live in a non-cooperative world. and B is “investing” for itself. Seen from B’s perspective, there’s a loss of “10” if they invest, a loss of “3” by doing nothing. So, they do nothing.

You see, there’s a Nash equilibrium hidden inside climate action, forestalling investment. Player B, knowing his own options and also knowing A’s options, fails to invest every time. And vice-versa. It’s stable. It’s optimal for the players.

The Transport Fuel Infrastructure Dilemma

Should obligated parties under the Renewable Fuel Standard build out the necessary infrastructure to distribute renewable fuels, or not?

When Congress passed the RFS in 2007, which called for 20 percent of US gasoline m to convert over to, essentially, ethanol — they weren’t simply out of their minds or unaware that most cars at the time were only certified for E10 ethanol blends.

They counted on an infrastructure build-out, which has only happened in a limited way — and the obligated parties have built almost nothing to distribute higher-ethanol blends. How could Congress have got it so wrong?

Perhaps, by not seeing the Nash equilibrium trapped within the RFS. Let’s take a look.

Oops, it’s the same Prisoner’s Dilemma we see in carbon.

There are four possible outcomes. All obligated parties invest, one invests but not the other, or none invest.

If all invest, the world is a better place and they recoup their investment and maintain market share. If neither invests, the world is a worse place economically in the long-term because of climate change costs, but they maintain relative market share.

If one invests but not other(s), they all get the limited reward of limited climate change action, but one bears all the cost and loses value because of loss of market share or margin compression when all the burden of the new technology is falling on one company, not both. One company is missing out on opportunities to invest in higher-reward projects, but not all.

So, we end up with the same chart.

Seen from the point of view of “the community”, there’s a clear benefit for B to invest. The result is a community loss of “16” if they fail to invest, “10” if they invest.

But we live in a non-cooperative world. and B is “investing” for itself. Seen from B’s perspective, there’s a loss of “10” if it invests, a loss of “3” by doing nothing. So, B does nothing.

The Problem of Mandates

Can the problem of the Transportation Fuel Dilemma be solved by government mandates? After all, the Renewable Fuel Standard is supposed to overcome market forces that give a negative result for the community by imposing a mandate that ensure a positive community outcome.

But, does Player A enforce a renewable fuel mandate, if Player B fails to build the infrastructure to distribute the fuel? And, if Player B knows that Player A won’t mandate what Player B won’t distribute, if B can convince A that he won’t build infrastructure, will the mandate be watered down?

There’s real reason to believe that this is, in fact, the case. The EPA’s lead on renewable fuels, Chris Grundler, told industry executives last week that the EPA is not in the habit of setting regulations than can’t be met. He also said “Congress could not have intended the production of vast amounts of renewable fuels, only to have them sit around in storage tanks. We gain the benefit through their use.”

It’s a similar chart in many ways. Seen from the community perspective, there’s benefit if the EPA enforces and obligated Party B builds infrastructure to distribute.

But seen from Player B or EPA’s individual perspective, as modeled here, it’s better for the former to do nothing and the latter to not enforce.

The Problem of Subsidies

OK, so mandates seem to have challenges, looking through the lens of game theory.  Why not simply place a price on carbon? If Project C (Clean) is less economically favorable than Project F (fossil), then add in a carbon price, and that will make people invest in carbon-friendly projects.

Well, the simplest way to explain is to introduce the problem of Project E (Elsewhere), that exists in an economy where there is no carbon regulation.

You see, it is tempting to see the situation like this chart below, where the margin compression or loss of market share is eliminated by the carbon price borne by the community. In that model, it is always favorable to invest, both for the community and the player.

BUT — and it’a big but, we’ve made an error in constructing our model. The two coalitions or classes of Players are not Player A and B both inside the carbon-priced single economy. Given that we are trading global commodities, the competition is between Player A who is inside the carbon economy and Player B who is outside the carbon single-economy, the free rider getting the benefit from a carbon regime without investing it it.

So, the chart remains the same as for the “problem of mandates”. “Invest” is not the winner.

The Carrot, the Stick and the Will to Act

So, what works for renewable fuels in a modern investment economy? The carrot of carbon prices, or the stick of mandates?

The answer might well be “neither”. Coercion within a model based on global commodity markets (for example, the Renewable Fuel Standard) runs into the Prisoner’s Dilemma, not to mention one that attracts unfavorable attention (e.g. anti-subsidy or anti-mandate rhetoric) and de-stabilizes what little investment support there is.

You might tell me that people who think that energy markets are free and unsubsidized are lunatics out for an airing. But investor hesitation on renewable fuels, over the issue of policy stability, is as real as Thursday.

What works? In the power sector, we see a different world based in regulated prices and monopolies, where actors can recover costs from investment in new technology (often, with a cost-plus profit baked in) via a “rate case” reviewed by an appointed public board there to balance the needs of ratepayers and regulated companies.

It is hard to see how solar and wind would have had the relative deployment success they have had their been the same market construction in power as in fuels.

Real-world actors galvanized to action

We see self-imposed mandates working in the aviation biofuels markets. IATA has set a goal of reducing carbon emissions 50% by 2050, and being carbon-neutral in growth after 2020. In the absence of a solar plane and practical limits on improving fuel efficiency, it works to some extent like a self-imposed mandate, and is leading to multi-million dollar strategic investments, large-scale offtake agreements, and close cooperation between producers and customers on infrastructure issues and certification.

Because it is not coercive, it is working, The Navy’s self-imposed “Great Green Fleet” initiative has much the same practical impact — namely strategic investments, offtake agreements, and cooperation on infrastructure issues and certification.

What is present in both sectors is “a will to act”, pressured by non-price factors such as customer pressure or national security concerns. We see companies such as Coca-Cola and LEGO, entering the market — albeit on the biomaterials side — driven by many of the same concerns.

The desire to be seen to be doing the right thing. Naturally, that’s the solution the prisoners in the Prisoner’s Dilemma never seem to figure out — the role of altruism in making for better community outcomes.

So they never experience them, the dirty little rats. And we never experience the benefits intended from the mandates that were established — becoming Prisoners in our own Carbon Dilemma.

But we might, by finding the will to go another way. Will we?

(Note from the author: A very inspiring look at game theory, specific to investment and capital markets, but very entertaining and thought-provoking, is Ben Hunt’s Epsilon Theory letter, which inspired much of the above, though we’ve been closely following game theory since the 1980s.)