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CSM

BSc. 2008

Energy and Environmental Economics

Session 1: Economics and Energy


Prof. David Elliott
Open University

Summary

Economics of energy
Energy prices and geopolitics
Energy subsidies: the role of political intervention
Privatisation and the liberalisation of energy markets

1. The Price of Power

1.1. Costs and Prices


You would think that it would be easy to say how much energy costs- energy is such a
tangible commodity which can be easily measured- in kilowatt hours or whatever.
Certainly it is easy to say how much gas or electricity costs to buy- i.e. the price of these
fuels to consumers. It's on everyone's bills- and it's around 6-7p/kWh for electricity at
present in most places in the UK. But that is not the same thing as the cost of energy i.e.
how much it costs generation companies to produce and deliver power to consumers.

The cost of generation is made up of the cost of the fuel, some proportion of the initial
cost of the generation plant and the cost of its operation and maintenance. To that
must be added the cost of distributing power via the national grid, and the cost
overheads involved with administration, marketing and so on.

The costs of fuel and of operation and maintenance are continuous, ongoing, recurrent
costs: the cost of building the generation plant is a one-off capital cost. In addition to
meeting the continuous costs, the initial capital expenditure must be gradually recovered
by income from sales. The initial capital may have been raised by borrowing money
from a bank, so the loan has to be paid back, with interest. Or the capital may have come
from investments made by shareholders in the generation company- and the investors will
be expecting profits in the form of dividends. Either way, there is an element in the price
charged to consumers to raise these payments.
Obviously the price that can be charged must depend on what consumers are willing to
pay and this too may change: for example competitors may undercut you by using
cheaper technology: either you follow suit or you try to make savings: but in the end a
company can only trade successfully if its costs are less than the price it can get!

Just as the consumer market can lead to price changes, so changes in the financial
markets can lead to changes in interest rates charged on borrowed capital. The result is
that generation costs can vary quite dramatically over time, even if fuel costs and wage
levels remain constant.

This variation makes it especially hard to provide estimates of likely future costs and
resultant prices. Two identical plants operating in identical ways in different investment
climates can have dramatically different generation costs i.e. if interest rates are high then
generation costs and prices will be high. And it become even harder if we are talking
about novel, untried technologies. So quite apart from competitive market based
variations in the levels of prices that consumers will be willing to pay for power, and
variation in fuel and wage costs, there is no absolute 'generation cost'.

Do remember this when we come to look at estimates of the costs of the various energy
systems in this course: what matters is the financial set up, the interest rates and payback
times being used- just as with household mortgages.

Despite these complications and uncertainties, companies do have to have figures for the
costs and at any particular time a plant will obviously have identifiable operating costs-
as well as a known initial capital cost . Some examples are provided below - showing
the original plant cost and operating costs for various energy technologies in the UK in
2004. These look to be fairly solid numbers, though inevitably there will be
disagreements about them. For example, the nuclear industry argues that new nuclear
plant will be cheaper than that shown here. But even leaving that aside, as indicated
above, how these costs then interact to give the actual prices that are charged for the
electricity adds yet more complexity- due, in part, to the need to pay back the original
capital outlay . For example, the 'plant cost' figures shown below are derived by a
relatively straightforward calculation of capital cost spread across the total number of
kWh's likely to be produced over the lifetime operation of the plant. Clearly that's an
accounting fiction, in reality that’s not how capital is repaid.

Table 1. Cost structure of main UK generating technologies


Technology Plant cost Fuel cost O&M Total Average
£/KW p/kWh p/kWh p/kWh p/kWh p/kWh
Gas 400-600 0.6 1.1 0.3 1.8-2.2 2.0
Wind 700-1000 1.7 0 0.8 1.9-3.1 2.5
Coal 750-1000 1.4 1.1 0.6 2.6-3.25 3.1
Nuclear 1500-2000 5.0 0.4 0.6 5.2-8.7 6.0

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1.2. Discounting
This moves us on to our second key economic factor influencing costs - concerning the
financial arrangements associated with borrowing capital: the concept of 'discounting'.
If you borrow money over a long period you expect to pay less back each month (pro
rata) but more in total overall. So there is a time value to money: money available now is
worth more ( and costs more to borrow) than money available later. To reflect this,
capital borrowing is sometimes discounted over time. Given a long pay back period the
repayments can be quite small, but the initial rate of repayment may be high.

I've simplified the argument considerably in the above brief explanation, as any
economist will tell you. A more conventional but more complicated explanation is based
in the value of money invested. If you invest £100 at a 10% interest rate you expect to get
£110 after a year or £260 after 10 years. The present value of this £110 or £260 can be
said to be £100: i.e. you have discounted the future sums back to the present value. This
is the basis of discounted cash flow analysis and net present value analysis. However
for our present purposes my simple explanation above will I hope suffice.
Until recently the UK Government used a 5% discount rate for major publicly financed
projects (under Margaret Thatachers adminstration it was put up to 8%, but was then
lowered, and recently the UK Treasury 'test discount rate' has been lowered from 6% to
3.5%), whereas the private sector typically used 10% and sometimes more- perhaps 15%.
That is because the time value of money is higher for private investors. Governments can
(in theory) afford to accept lower (and longer) rates of return on capital invested, since
part of the return can be measured in social terms i.e. the provision of some public service
or facility.

The actually achieved rates of return on capital invested and the interest rates charged
by banks are likely to differ from the discount rates, since other factors than just the
time value of money are involved, including risk factors, and we also have to remember
inflation i.e. changes in the value of money.

For our purposes however, what you need to remember is that, for example, it is going to
cost you a lot more to borrow money to build a power plant under a private sector
10% (or higher) discount rate than under a public sector 5% (or lower) discount
rate. We will be coming back to this point regularly.

If you want to get to grips with the details of discounting and other such concepts and
techniques, see Sue Walkers appendix in Godfrey Boyles "Renewable Energy" Open
University Press/Oxford University Press 1996. Or the chapter on Costing by Bob Everett
in "Energy Systems and Sustainability' in G. Boyle et all, Oxford University Press/OU
2003.

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1.3. Fuel Subsidies
The third key factor affecting costs is that the price of fuels is not just market
determined. Governments intervene in this key market to reflect domestic political and
economic factors which are linked primarily to social and economic rather than energy
production issues and concerns.

In some countries some fuels are heavily subsidised to sustain employment in key
industries or to ensure 'cheap' fuel supplies for key industries. For example, Germany
pays a £3.6 billion annual subsidy to its coal industry- and the UK coal subsidy, although
reduced in recent years, has been estimated to put 4% extra on electricity bills. There are
also more general strategic factors at work: Governments will want to ensure security of
supply and a reliable domestic energy base free from foreign influence.

Tables 2 and 3 below, from a report written by economists from the Vrije University in
Amsterdam, 'Energy Subsidies in Europe', give some idea of the different levels of
subsidy that the various energy options have attracted in the UK and in Europe.

The large imbalances between support for fossil and nuclear and support for renewables
and conservation have lead to criticism from environmental groups. For example, in its
briefing paper on fossil fuel subsidies ('Stop stoking the fire' May 1997) Greenpeace say
that for every £1 of public money used to support the development of renewable energy,
fossil fuels have received over £100 in direct subsidies in the period 1990-1995, and
comment:

'The funding pendulum has been swung in favour of fossil and nuclear energy for so long
that it will take substantial investment from the new Government before renewable and
energy efficient industries have received anything approaching 'fair treatment'.

Table 2 Total UK energy subsidies for the period 1990-1995 (£ million)


1990-1995 Percentage
Fossil 4,077 24%
Nuclear 11,544 64%
Renewables 379 2%
Energy conservation 1,236 7%

Table 3 Total EU energy subsidies for period 1990-1995 (£ million)


Annual subsidy Percentage
Fossil 2124 43%
Nuclear 1716 35%
Renewable 528 10%
Energy conservation 582 12%

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On the European situation Greenpeace added: 'The EU-wide funding programmes have
done more to encourage global warming and nuclear power than promote alternative or
efficient use of energy. In the five years since EU states signed up to the Climate
Convention, the European Commission has spent £3.2 billion in subsidising the fossil fuel
and nuclear industries. In stark contrast, renewable energy and energy efficiency
technologies have received less than a third of this in financial support.'
The end result of the various subsidies and political interventions is that the actual
'technical' costs of fuel may not be the key factor in shaping investment patterns. Non-
energy and even non-economic issues may end up dominating.

1.4 Comparative Figures


Although as we have seen, it is hard to come up with uncontentious figures for energy
costs across the board and over time, it is usually possible to provide 'snapshot'
estimates, at any one time, for specific projects.
However, we face a further set of problems if we try to use these to make comparisons
between different types of technology. The financial arrangements for borrowing money
may be different , different rates of return and discount rates may apply and so on. It's an
'apples and pears' problem: a hydro plant may have been built 100 years ago and its
capital debt may have been paid off long ago, so it can generate power at very low costs
(less than 1p/kWh perhaps). Is it fair to compare it to a brand new combined cycled gas
turbine plant?
Also, as we have seen, some technologies have been heavily subsidised by Governments
for a variety of policy reasons. Nuclear power is a case in point - it has been estimated
that the UK subsidy has been the equivalent of £1000 per kilowatt installed.
However, the bottom line is that companies have to sell power, and we do have figures
for the prices charged to consumers and the wholesale price of power traded by
generators, within the liberalised electricity markets. Recently in the UK the going price
for electricity in the wholesale market fell to around 1.7p/kWh-it had fallen from around
2p/kWh under the impact of the new competitive trading mechanism introduced in 2001.
In practice what this has meant is that the cheapest source has dominated, and that is gas,
which can be used in gas turbines to generate at a wholesale price of around 1.6p/kWh.
All the other sources, except some well established hydro plants, are more expensive,
with the most expensive being nuclear power, which needs about 2.1p/kWh to break
even. That is why the UK's main nuclear operator, British Energy, sought new subsidies
from the government over the last few years.
The main costs for nuclear are capital (construction) costs, which can be three times that
for coal or gas plants, partly because of the need for sophisticated safety systems- which
also adds to the operational costs. The raw fuel costs are quite small, perhaps 2% of total
costs, although the fuel has to be extensively processed which adds to the cost. Even so
the total fuel costs comes out to be 20% of overall costs, or about one third of the fuel
costs for coal plants. Waste disposal adds about another 5% to costs and the need to put
money aside for eventual plant decommissioning adds a further 5%

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By contrast some renewable energy technologies are getting to be competitive, for
example wind projects can generate at under 2p/kWh in some locations in the UK.
This is partly because the make up of the costs for renewables differs substantially from
the conventional sources, primarily since, with most types of natural flow based
renewables, the fuel is free.
However that does not mean there are no costs in generation: you still have to build, run
and maintain the generation plant. With renewables there is also another factor effecting
costs- the variability of the renewable source over time. Given that wind, wave, tidal and
solar energy is intermittent, the earning power of the plants will also vary, making it hard
to make comparisons with conventional plants which can supply power on a more nearly
continuous basis (so called 'firm' power).
To make comparisons easier, the figure for the installed capacity of renewable energy
plants (sometimes called the 'name plate' capacity) is usually converted into a figure
reflecting the equivalent firm capacity.
Let’s use windpower as an example. Typically, given the variability of the wind, wind
turbines in the UK can only deliver full power on average for about 30% of the time: this
figure is known as the 'load factor'. The strict definition of load factor is actually more
complex, but this will suffice for our purposes. However its worth noting that 30% is only
an average figure. The load factor figure for specific machines will depend on the wind
turbine design, the site and the wind regime: higher load factors, up to 40% and more,
have been reported for modern machines on good sites, for example in Scotland and in
the USA .
To make a fair comparison with conventional plants, it is important to realise that,
although fossil or nuclear fuelled plants do not have intermittent energy inputs and
therefore have much higher load factors, even so, they typically can still only achieve
load factors of around 60-70%. For the sake of simplicity let us use a 30% load factor for
wind turbines and 60% for conventional plants.
On this basis, to generate the same amount of power you would need twice as much
windfarm generating capacity as you would conventional capacity. Put the other way
around, you would expect wind turbines to generate about half as much continuous power
as conventional plants with the same capacity. In the UK wind turbines and other
renewable energy devices using intermittent sources are given a rating in terms of their
'declared net capacity', or 'DNC', to reflect this comparison.
The DNC conversion figure adopted by the UK Department of Trade and Industry for
wind turbines is actually 43% , rather than the 50% derived using the 30% and 70%
figures (i.e. the DTI's DNC figure is 30/70x100%). So the actual equivalent DNC
generation capacity of a windturbine is considered to be 43% of its full rated capacity.
(For comparison the DTI's DNC conversion figure for tidal and wave energy systems is
33%, and for solar/photovoltaics is 17%. Hydro is given a 100% rating). To summarise,
you need about twice as much installed wind generation capacity to generate the same
continuous output as you would get from a convention plant. That means the capital cost
is larger, which in turn means a higher overall price for power.
A final general word of warning on generation costs. When looking at quoted generation
costs, it is important to take note of whether they relate to existing plants, or to new
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plants. In the case of existing plants, most of the construction costs may have been paid
off, so that the only significant costs are the running costs, which may be relatively low.
For example, in its evidence to a Trade And Industry Select Committee hearing on
Energy Security in 2001,the British Nuclear Industry Forum claimed that the generating
costs for the existing nuclear plants was as low as 1.8p/kWh, (which was similar to the
cost of natural gas fired generation at that point). That is why it is often seen as attractive
to keep plants running beyond their originally specified closure date, assuming that any
extra costs required to ensure safe operation over an extending life time does not wipe out
the cost advantage from their continued operation. New plants may of course have
improved technology which may make them cheaper to build and/or run, but you do have
to pay to build them.

2. International factors
2.1 National Differences
The price and cost comparisons we have made so far are based on the UK. However,
even with the same basic technology, costs can vary around the world. This is because of
differences in construction costs (labour, materials and the cost of borrowed capital),
operational cost (mostly labour, since the fuel costs are relatively small) and, more
generally, differences in the investment markets , financial support arrangement and
subsidy structures. Table 4 presents some examples of the differences in the case of
generation costs for nuclear power.

Table 4. Levelized nuclear generation costs (investment + O&M + fuel, costs


In 1991 US cents per kWh, including decommissioning and waste disposal):
Canada 2.98
Finland 3.01
France 3.28
West US 4.21
Midwest US 4.27
Northeast US 4.37
UK 5.00
Germany 5.31
Japan 5.37
From Nordhaus 1997 ‘Swedish Nuclear Dilemma’

As noted earlier, one of the biggest differences is whether the project is carried out under
public or private sector financial arrangements. In the public sector, a 5% test discount
rate was common, more recently 8% in the UK, but in the private sector context investors
might expect rates of return of 10-15% or more. So one possible reason for some of the
differences between countries as shown in Table 4 is that some have been financed via
the public sector, but are now run privately ( e.g UK), some were built with government
support and remain in the public sector (e.g France, for the moment), while a few were
and are private sector plants ,with no direct subsidies (e.g USA).
Table 5 presents some data on costs for a wide range of technologies, again showing the
difference around the world.

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Table 5 : Electricity Generating Costs For Various Alternatives
_______________________________________________________________

Euro cents/kWh Coal* Gas Bioenergy Wind Solar PV Nuclear


(1990 values) Combined
Cycle
________________________________________________________________
Austria 3.6 3.4 3.6 7.2 64.0 5.9
Belgium 3.2 2.8 3.7 7.2 64.0 4.0
Denmark 3.6 2.9 3.9 6.7 85.3 5.9
Finland 3.2 2.6 3.9 7.2 85.3 3.8
France 3.2 3.2 4.0 7.2 51.2 3.4
Germany 3.2 3.5 4.3 6.8 64.0 5.1
Greece 3.5 3.5 4.0 7.2 51.2 4.6
Ireland 3.2 3.2 4.5 7.2 85.3 4.7
Italy 3.2 3.4 4.0 7.2 51.2
5.0
The Netherlands 3.6 2.6 4.0 7.2 64.0
5.1
Portugal 3.2 3.4 4.3 7.2 51.2 5.9
Spain 3.6 3.5 4.3 7.1 51.2 4.7
Sweden 3.6 3.3 3.4 7.2 85.3 4.7
United Kingdom 3.2 2.6 3.8 7.2 64.0
4.3
_______________________________________________________________
* Pressurised Fluidised Bed Combustion

Note:Production costs are for power generation at 7,000 hours and exclude
excise taxes and subsidies.

Source: Commission of the European Communities (2000)

Note that in Table 5 figures are given for nuclear even for countries that do not ,or no
longer, operate nuclear plants.(including. Denmark , Ireland, Italy) Presumably these
are therefore estimates of what it would cost.

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2.2 Energy as a key globally traded commodity
In additional to national differences, there are international factors to consider. Some
fuels are traded internationally- and global competitive mechanisms may have a impact
on the 'domestic', i.e. national, price of energy. How do these global factors influence
the cost of energy?
Energy is a big business. Providing generation equipment is an expanding industry, with
demand for power generation capacity reckoned to be likely to grow between 250GW
and 900GW annually- compared with the worlds current total capacity of around
2900GW. Fuel provision is an even bigger business- and is increasingly international.
For example the oil companies are amongst the most powerful in the world, and the
decisions they make concerning prices can have massive effects on the world economy.
The most obvious example of that was in 1973 when OPEC, the oil cartel, raised the
price of oil dramatically and precipitated a major economic crisis around the world.
Coal is also traded internationally (e.g. Australia is currently a major exporter to the
Asian Tigers) and gas is increasingly being traded around the world (e.g. W. Europe gets
about 20% of its gas from Russia) and this trade is likely to expand. Electricity
(produced mainly from coal or nuclear) is also traded- around Europe for example- and
this trade too is likely to expand as markets are liberalised.
The prices that are asked for these traded commodities obviously reflect the costs of
exploration, extraction , processing and transport, but there are also other factors, not
necessarily directly linked to energy production costs, including national and regional
policies and politics. The 1973-74 Oil Crisis provides an example: the OPEC price rise
was introduced because of resentment amongst Arab oil countries at the support of the
West for Israel during the Yom Kippur war. More recently the US spent more than $30
billion on the (first) Gulf war- in effect, some argue, in order to safeguard access by the
West to Middle Eastern oil supplies
So geo-political factors can be crucial. It is not just a matter of middle east oil: currently,
since gas is becoming so important to the world energy economy, there are growing
tensions over maintaining access ( e.g. for the West) to reserves, some of largest of which
are in politically sensitive areas ( e.g. in Russia and in Algeria).
In addition to geo-political factors there may also be national economic factors, other
than just the cost of energy production, which may influence the price of globally traded
energy. For example countries with large reserves of coal, oil or gas, but little capacity
for domestic use, may choose to sell them off cheaply to attract foreign exchange.
There are also situations where countries find they have excess generation capacity, for
example due to overestimates in forecasts of demand, and need to 'dump' power overseas.
France seems to have faced this problem, with its large nuclear programme. France
obtains nearly 80% of its electricity from nuclear plants, but these were funded not by
charging consumers higher rates, as in the UK, but by borrowing on the international
money markets. However demand has not risen as much as expected. So France is selling
nuclear electricity at relatively low rates to other European countries, including the UK.
(It should perhaps be noted that this cheap fuel strategy has its problems: evidently the

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profits from the sale of Frances cheap nuclear power are not sufficient to pay the interest
on the capital loan).

2.3 Privatisation and Liberalisation


The analysis so far has looked at the way prices and cost are influenced by various factors
additional to the basic technical factors. Inevitably one of the main factors is the way in
which markets are organised, and this is changing, nationally and globally. .
In the period after the Second World War, at least in Europe, state subsidies were
provided for nationalised energy utilities. However the political shifts in Europe over the
last decade or so have led to the privatisation of nationalised utilities and the
liberalisation of energy markets, that is the removal of some government controls.
In the UK, gas was privatised in 1986 and the Central Electricity Generation Board was
privatised in 1990 and the electricity and gas markets have been progressively opened to
competition. That initially meant there were a lot of relatively small companies
competing with each otter, including 12 regional electricity companies. However, a
process of re-concentration then took place vertically and horizontally, with some supply
(generation) and (retail) distribution companies merging and most companies changing
hands in a spate of take-overs. By the end of the 1990' , few of the original companies
remained and currently much the UK power system was owned by two German and one
French company - market liberalisation has also occurred across national boundaries.
The internationalisation of the energy market is likely to continue. As we have seen,
energy, in the form of electricity or gas or oil, is already traded around the world, but the
new global market that is emerging is making this much easier. For example changes in
European legislation have increased the scale of trade in electricity and gas within
Europe.
There is understandably much business enthusiasm for this process, and the Labour
Government seems to share it. And certainly, completing the Single European Energy
Market has been and still is a top EU priority.

2.4 An uncontrolled global market?


The benefits of open trading in energy are supposed to be that competition will drive
down prices and increase efficiency. Certainly in the UK privatisation has already led to
some consumer price reductions and to the rationalisation of the energy supply industries
- even if what that has meant is a dramatic decrease in employment, most notably in the
coal industry but also in electricity, gas and nuclear.
Quite apart from social dislocation problems due to rationalisation, there may be some
more general economic problems with liberalisation. Whereas before the energy markets
supplied by generation companies were primarily domestic and relatively stable, with just
excess being sold abroad if possible, the new much larger Europe wide, and indeed world
wide, energy market could make the whole system much less stable.
Whereas before national Governments could direct the overall pattern of energy supply,
in the new global market, decisions on the marketing and trading of energy are mainly the
preserve of large private companies often operating on a global basis.

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In the European context, the European Union has tried to develop controls to ensure
market stability, but the whole aim of the exercise is to open up markets rather than
constrain them with regulatory interventions.
However the economic forces that have been unleashed by liberalisation within Europe,
and around the world generally, are very large and it remains to be seen whether the new
large scale energy markets will be stable. It also remains to be seen whether the new
energy markets will take environmental considerations into account. Many
environmentalists are sceptical, and, as we shall see, there is pressure to develop more
effective environmental controls, given that concerns over the economic cost of climate
change are growing.
Moreover, quite apart from environmental concerns, there does seem to be a conflict
between free market ideology and the need for regulatory control at all levels. For
example, can we really leave it up to the market to ensure security of supply? Under
nationalised systems, the government was ultimately responsible for keeping the lights
on- setting prices and ordering new plants to meet projected demand. Under the current
privatised and liberalised system, it's mostly left to companies to interpret market
opportunities, with, at best, weak regulation.
In a Consultation Document on Microgeneration, published in June 2005, the
Department of Trade and Industry spelt it out clearly : 'The framework underpinning our
competitive energy markets was established to provide market based solutions to our
energy needs, governed by an independent regulator. Intervention by the Government to
the extent of setting a price for exported electricity would be an unwarranted intervention
that could have adverse effects on the confidence and certainty our liberal framework
provides for investors'.
Similar views were forthcoming from the Minster, Malcolm Wicks, in relation to the
security of UK gas supplies: 'As set out in the White Paper "Our Energy Future:
creating a low carbon economy" published in February 2003, the Government believe
that allowing the free operation of a competitive UK market, within an appropriate
regulatory framework, is the most efficient way to ensure security of gas supply.
Commercial operators have every incentive to ensure diverse sources of gas, supply
routes and entry points so as to reduce the risks arising from supply interruption from
any one source. The current UK gas market arrangements are already delivering a
number of competing gas import projects, potentially delivering gas from such diverse
sources as Norway, Belgium, the Netherlands, Russia, Algeria, Qatar, and other
Liquefied Natural Gas exporters' (Parliamentary Debate, 13th June 2005).

As we move towards an international market in all types of energy, and as climate change
issue become ever more u worrying, weak regulation may not be enough- and certainly
not weak regulation which allows the old centralised national energy companies to be
replaced by a few giant multinational conglomerates.

3. Conclusion.
We have looked at the various factors that influence the price and cost of energy- but so
far we have not looked at the so called 'external costs'- that is the costs of generating and

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using energy that do not fall directly on the generators or users, the most obvious being
the cost of any environmental impacts. That’s the topic of the next session.

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